Italy can save itself to save euro zone

By Neil UnmackThe author is a Reuters Breakingviews columnist. The opinions expressed are his own.

LONDON — The growing Italian crisis leaves the euro zone out of options. The country is both too big to fail and too big to bail. But Italy can deal with its own crisis.

It’s surprising that the sovereign debt crisis didn’t reach Italy sooner. The country’s economy is an explosive cocktail of low growth and high debt — currently higher than both Portugal’s and Spain’s at 120 percent of GDP. Political tensions between Silvio Berlusconi and Finance Minister Giulio Tremonti, credited with keeping Italy’s deficit down, have woken markets. Ten-year yields have risen by 1.2 percentage points since the start of July.

Italy has some cushion. Its current average cost of debt stands at 4.125 percent. But it needs to refinance over 860 billion euros of relatively inexpensive debt by the end of 2015, according to Evolution Securities. Barclays Capital estimated in June that spreads of 200 basis points more than seven-year Bunds could be unsustainable over the long term. They are now at 370 bps.

Rising bond yields present the euro zone with a big headache. Italy cannot fail, and is too big to bail out. The European Central Bank could try to bring down yields by purchasing the country’s bonds, but Italy’s 1.6 trillion euro debt stock means the ECB’s impact would be mostly symbolic.

Italy has some strengths to fall back on. Tight fiscal management by Tremonti has kept its deficit on par with Austria and below France. Its bond market is buttressed by a loyal following of domestic investors who buy about half of its debt, far more than say Ireland or Portugal. It managed to dodge the real estate bubble that plagued Ireland, leaving its banks and taxpayers relatively healthy — even if the sovereign troubles now risk becoming a source of instability for the banks.

It has one big problem: politics. The current government’s fragile position and recent infighting make it harder for investors to believe Italy can muster the political cohesion to force through further austerity measures and economic reform. Even if Parliament approves a 47 billion euro austerity package this month designed to achieve a fiscal balance by 2014, the fact most of the measures are delayed until 2013 and 2014 creates uncertainty.

Even then, Italy needs more than austerity. Anaemic growth rates — Deutsche Bank is forecasting just 0.8 percent in 2011 and 1 percent in 2012 — leave it vulnerable to rising debt costs. Further structural reforms, particularly labour markets, would send a powerful signal to investors. Italy can make it, but it is walking a narrow path.